The ability to calculate ROI on a rental property is a critical skill if you want to become a successful real estate investor. ROI calculations tell you what you can expect when you add a property to your portfolio, and whether it is worth pursuing.

Of course, ROI calculations alone won’t be your only consideration. Every investor has different goals and strategies, and you’ll need to know how each potential property fits into yours. You’ll also need to conduct additional due diligence to ensure you don’t end up with any unpleasant surprises. 

Nevertheless, calculating ROI is a vital step in the purchase process.

Understanding ROI

ROI stands for “return on investment.” 

It’s a measure of your potential profits: the money you can expect your property to earn after all of the repair, maintenance, insurance, taxes, and management expenses are accounted for. 

The basic ROI formula is: 

(Gain on Investment – Cost of Investment)/Cost of Investment = ROI

However, as you might imagine, this formula can become more complex when you’re talking about real estate, especially as some expenses aren’t so easy to predict. 

ROI for Cash Buy Rental Properties

The ROI calculation is relatively simple if you purchase your property with cash.

The ROI for a rental property you’ve purchased with cash will be:

 (Annual Rental Income – Annual Operating Costs)/Purchase Price of Property

You don’t have a mortgage, so you don’t have to factor the mortgage into your ROI calculations.

As long as you’re not spending more money on the property than you’re getting back in rent, you’re staying afloat. Ideally, of course, you’re making enough of a profit to make the work of owning a company worth your while.

ROI For Financed Properties

When you’re financing a rental property, the ROI calculation looks like this:

(Annual Rental Income – Annual Operating Costs) / Mortgage Value = ROI 

For example, if you’re renting a duplex at Florida’s median rental rate of $2,475, then your annual rental income is $59,400. In Florida, average operating costs are $0.26 per dollar of rent, or $15,444.  If you bought the duplex for $285,000 and financed $228,000 of it, then your ROI would be 19%. 

The mortgage isn’t factored into the annual operating costs. Instead, the amount you’re paying in financing is handled by using the mortgage value as a divider. This is why you can’t simply subtract all of your operating costs and your mortgage payments from your annual rental income to get a sense of your ROI. 

Financing: a key to higher ROI?

If you’ve run all the math above you might notice that the ROI on purchasing the duplex outright would have been 15%…significantly smaller than the 19% you receive on the financed property. 

This is the power of leverage: of using borrowed money to maximize your returns. When you take out a mortgage on a financed $285,000 duplex you’re only using $57,000 of your own money to earn the same $43,956 per year.

Given DSCR loans don’t offer any limits on the number of loans you can take out, some investors are able to grow their portfolios very fast, especially if they are talented at filling units and keeping tenants happy so they don’t reduce their annual rental income with a lot of high-vacancy time. 

See also: DSCR Loans

What does a good ROI on an investment property look like? 

While a good ROI can vary based on your goals, you typically want to aim for at least 6%. A return of 10% or more would be an excellent return on investment. 

The median return is at 8.6% annually for long-term rental properties. 

Short term rental properties often enjoy high rates of return at 15% or higher, but short term properties are riskier. Long term landlords have more power to screen and select tenants. Tenants live in those properties, so they tend to do less damage. 

Short term rentals can be prone to renters who are harder on the property, which can skyrocket repair costs. 

What is the 2% rule?

The 2% rule is a stricter version of the 1% rule, which helps you maximize your return on investment by setting your rents correctly.

To determine the monthly rent:

Purchase price of the property x 0.01 = Monthly Rent

In the above example, the duplex purchase price was  $285,000. That means you should be making at least $2,850 in rent every month, or at least $1,425 per unit. When you calculate your ROI you should use the actual rents you intend to charge. 

If you’re using the 2% rule, you’d set the rent at $2850 instead. 

The 1% rule is not the only consideration you should be thinking about when you set your rent. You should consider repair costs and local market conditions. 

But with this rule, you can see that setting your rents somewhere between $1425 and $2850 will be the right target to realize ROI on your investment property while helping to keep renters inside your units. 

See also: Using Rental Income to Qualify for a Mortgage: Unlocking New Home Opportunities with Alex Doce

Maximize Your ROI With Alex Doce 

Keeping your mortgage rates and fees low is one method to ensure you maximize your ROI. The less you pay for your mortgage, the more ROI you receive on your rental property.

Plus, when you work with Alex you can receive expert advice on any property you’re considering.

Are you ready to become a real estate investor? Schedule a consultation with Alex Doce today.